Large European banks call for further integration, but is it in consumers’ interests?
Those of a certain age may remember the fanfare which heralded the introduction of the Single European market (SEM) on 1 January 1993. It promised the removal of internal barriers to the movement of goods, services, capital and people. One sector that was noticeably absent from the single market, however, was banking.
Moves towards banking union only started after the global financial crisis in 2008. However, as a report published on the 2 September 2025 by the Association of Financial Markets in Europe (AFME) highlights, the institutional frameworks of banking in the EU are still deeply fragmented – the promised integration through the European Banking Union (EBU) is still incomplete. This has put European banks at a competitive disadvantage in global markets compared with rivals from the USA and Asia, thereby reducing their profitability and growth prospects. The report called on the European Central Bank (ECB) and national regulatory authorities to remove hurdles to cross-border banking services in the EU. This would enhance the strategic position of European banks.
In this blog we will trace the development of the EBU and analyse the current state of integration. We discuss the AFME proposals for achieving greater integration and highlight their benefits for large banks. We also analyse the barriers which limit full integration and examine the risks that retail customers might see few benefits from the proposed changes.
What is meant by European Banking Union (EBU)?
The 1993 Single European Market (SEM) in goods and services removed internal barriers to the movement of goods, services, capital and people within the EU. As part of this, there were harmonised standards and regulations for goods and services, no capital controls, mutual recognition of professional qualifications and common regulations on consumer protection, product safety, environmental protection and labour rights.
This integration of previously restricted domestic markets was designed to boost economic growth, employment and competitiveness by increasing trade and investment flows. Offering consumers greater choice would expose firms to greater competition. This would drive down prices and encourage greater efficiency and innovation. It has generally achieved these goals across many industries.
However, banking was excluded from integration. The 1985 White Paper, Completing the Internal Market, proposed the liberalisation of financial services, but banking remained regulated at the national level. This was influenced by interrelated economic, political and institutional forces, national sovereignty and political sensitivities, fragmented regulation and concerns about risk.
Even as the EU moved towards economic and monetary union (EMU) during the 1990s, there was no discussion of integration for the banking industry. However, that changed following the 2008 financial crisis and 2011 eurozone crisis. Both episodes exposed vulnerabilities in the EU banking system which required taxpayer support. It was proposed that deeper integration of the banking sector would ensure its stability and resilience. This stimulated moves towards European Banking Union (EBU), starting with the European Council agreeing its creation in 2012. There are three institutional pillars to the Union:
- The Single Supervisory Mechanism (2014) for systemically important financial institutions (SIFIs) ensures consistent oversight. SIFIs are banks with over €30 billion of liabilities or 20% of national GDP.
- The Single Resolution Mechanism (2016) manages the orderly resolution of failing banks with minimal costs to taxpayers. There is a central board for resolution decisions and a fund financed by the banking industry to support resolution actions.
- A European Deposit Insurance Scheme (still under negotiation) is proposed to protect depositors uniformly across the banking union against bank default.
The Union is intended to operate under a harmonised set of EU laws, known as the ‘Single Rulebook’, which includes implementing the BASEL III capital requirements, regulating national deposit insurance and setting rules for managing failing banks.
What is the state of integration at present?
Moves towards European Banking Union (EBU) have contributed to enhancing the resilience of the European banking system. This was one of its major objectives. European banks are much more secure having increased capital and liquidity levels, reduced credit risks and become less reliant on state-aid. They are also less profitable.
The AFME report points to remaining gaps in Banking Union which raise the cost for banks offering cross-border retail banking within the EU and limit the incentive to do so. The report identifies four such gaps.
1. Ring fencing. Although there is a single supervisory mechanism for large systemically important institutions, since the financial crisis national regulators have implemented ‘ring-fencing’. This aims to protect retail banking activities from riskier investment banking. Ring-fencing retains liquidity, dividends and other bank assets within national borders to protect their retail banking sectors from contagion. The ECB estimates €225 billion of capital and €250 billion of liquidity is trapped by such national restrictions. Further, unharmonized and unpredictable use of capital buffers adds complexity for capital management at a multinational level. This particularly impacts large institutions. Banks’ cross-border activities are impeded since they are restricted in the way they can use capital and liquidity across the bloc.
The report argues that the stringent requirements of the ECB and the multiple layers of macroprudential requirements imposed at national level have led to an unnecessarily high level of capital. This disadvantages large European banks compared to their international competitors.
2. Impediments to cross-border M&As in banking within the EU. This is due to cumbersome authorisation processes, involving multiple authorities at both national and supra-national level. Further, national authorities may interfere in the process of M&As in a bid to prevent domestic banks being acquired by ones from other parts of the EU. A recent example is UniCredit’s bid for Germany’s Commerzbank, which the German government opposes. These characteristics restrict opportunities for consolidation and efficiency gains for European banks.
The AFME report estimates that once eurozone banks grow beyond €450 billion in total assets, they suffer from negative synergies putting them at a competitive disadvantage to global competitors. Indeed, US banks are able to leverage scale economies from their domestic market to enter large EU markets. An example is JP Morgan’s entry into multiple EU markets through its Chase brand.
3. Contributions to the Single Resolution Fund (SRF) are complex and lack transparency. This makes it difficult for banks to predict future commitments. The fund itself and its target level were determined at a time when banks had low buffers. Since then, European banks have raised their loss absorbing capacity and the AFME report proposes that further increases in contributions to the fund need to be carefully considered and reviewed.
4. The Deposit Guarantee Scheme remains unimplemented and there are still differences in national schemes. This situation creates uncertainty for banks, which would like the European scheme for large systemically important institutions to be implemented fully.
These AFME proposals focus on the aspects of banking union which benefit large European institutions in their strategic competition with global rivals. These aspects would create ‘European’ banks as opposed to ‘national’ ones. This would give them the scale to be ‘champions’ in global competition. In particular, the large banks want lower capital requirements and the relaxation of national ring-fencing for retail banking to allow them greater freedom to achieve scale and scope economies across the bloc.
To what extent this will benefit retail customers, however, is debateable.
Will retail banking customers benefit?
Retail banking across Europe remains deeply fragmented, with significant price differentials from country to country. The following table illustrates pricing differentials for two retail products – loans and mortgages – across a sample of EU countries for July 2025.
The data show a range of average interest rates offered across the countries with a range of 5.03% for loans to households and 0.92% for new mortgages. These price differentials reflect a broad array of factors, not least the different institutional legal and risk characteristics of the national markets. They also reflect varying degrees of competition and the lack of cross-border trade in retail banking products. Retail banking remains a largely domestic industry within the EU. Cross-border banking services remain a marginal activity with non-domestic retail deposits rising by just 0.5% and non-domestic retail loans rising by just 0.3% between 2016 and 2024.
There are both natural and policy-induced barriers, which means that retail banking will remain largely segmented by nation.
On the demand-side, retail banking is largely a relational rather than a transactional service, with consumption taking place over a long time-period with significant financial risks attached. Even with deposit insurance and a lender of last resort (the central bank), consumers exhibit significant loss aversion in their use of retail banking services. Consequently, trust and confidence are important characteristics for consumers and that means they are likely to prefer to use familiar domestic institutions.
Further, perceptions about switching costs mean that consumers are reluctant to change suppliers. Such costs are exacerbated by language, cultural and legal differences between European countries, which can make the perceived costs of banking beyond national boundaries prohibitively expensive and create a preference for local institutions.
Consumer preferences can also create idiosyncratic market structures for retail banking services in particular countries. For instance, in several countries across the EU, notably Germany, mutualised credit unions account for significant shares of retail banking. This may limit the potential for foreign banks to penetrate Europe’s largest market.
There are also policy-induced obstacles to cross-border retail banking which operate on the demand-side. These include discriminatory tax treatment of foreign financial services which deters their purchase by consumers. Further, there are still eight different currencies used in the EU across the 27 member states (Denmark, Poland and Sweden are three significant examples). This creates costs and risks associated with currency exchange for consumers that may deter their use of cross-border deposits and loans. The full adoption of a single currency across the EU seems a long way off, which will limit the potential for a single banking market, particularly in the retail segment.
Retail banking as a public utility
Some argue that retail banking is a public utility and should be regulated as such. It has a simple business model, taking deposits, making payments and making loans. Like other utilities, such as water and energy, retail banking is an essential service for the smooth functioning of the economy and society. Like other utilities, bank failures create severe problems for the economy and society.
Since the financial crisis, stability in retail banking has been much more highly valued. In the period preceding the crisis, banks had used retail deposits to cross-subsidise their risky investment banking. The bank failures that resulted from this had severe economic consequences. The danger today is that by relaxing capital and liquidity restrictions too much, large banks may once again engage in risky behaviour, subsidised by retail banking – for example, by engaging in cross-border M&As. These may benefit their shareholders but provide little benefit to retail customers.
Further, allowing these large banks freedom to move funds around the bloc may lead to capital being concentrated in the most profitable markets, leaving less profitable markets / countries underserved. Retail banking, as a public utility, should be required to provide services there.
Who ultimately benefits?
The integration of banking services in the EU has progressed since the financial crisis, producing a more resilient system. However, there are features of retail banking which mean that integration which benefits consumers may be difficult to achieve.
Addressing the policy gaps identified by the AFME report may benefit large European banks by facilitating the scale economies to make them competitive internationally. However, until consumers are prepared, or able, to source banking services beyond national borders, they will see little benefit from European Banking Union (EBU) through lower prices and/or better service. The nature of retail banking in the EU suggests that this is unlikely any time soon.
Furthermore, since retail banking exhibits features of a public utility, regulators need to be wary of permitting the type of behaviour by large institutions which creates dangerous systemic risk. The worry is that, in the drive to create ‘European Champions’ in banking, regulators ignore the potential impact on retail customers.
Articles
Book
Report
Data and Information
Questions
- Using an average cost (AC) schedule, illustrate the efficiency benefits for large European banks from banking union.
- Analyse the sources of efficiency gains that European banks can gain from cross-border M&As.
- Explain how European retail banking customers could gain from such efficiency.
- Analyse why they may not.
- Analyse whether retail banking in Europe needs to be regulated as a public utility.
The UK government announced on 14 October 2024 in a ministerial statement that it intended to raise the threshold for the ring-fencing (separation) of retail and investment banking activities of large UK-based banks. These banks are known as ‘systemically important financial institutions (SIFIs)’, which are currently defined as those with more than £25bn of core retail deposits. Under the new regulations, the threshold would rise from £25bn to £35bn.
Ring-fencing is the separation of one set of banking services from another. This separation can be geographical or functional. The UK adopted the latter approach, where ring-fencing is the separation of core retail banking services, such as taking deposits, making payments and granting loans to small and medium-sized enterprises (SMEs) from investment banking and international operations. The intention of ring-fencing was to prevent contagion – to protect essential retail banking services from the risks involved in investment banking activities.
Reducing regulation to increase competition
Raising the limit is intended to facilitate greater competition in the retail banking sector. In recent years, US banks, such as JP Morgan and Goldman Sachs, have been expanding their depositor base in the UK under their respective brands – Chase UK and Marcus.
These relatively small UK subsidiaries were not ring-fenced from their wider investment banking operations as their retail deposits were under (but not far under) the £25bn limit. However, this restricted their ability to increase market share further without bearing the additional regulatory burden associated with ring-fencing that much larger incumbents face. Raising the threshold would allow them to expand to the higher limit without the regulatory burden.
The proposals are part of a broader package of reforms aimed at reducing the regulatory burden on UK-based banks. The hope is that this will stimulate greater lending to SMEs to boost investment and productivity.
The proposals also include a new ‘secondary’ threshold. This will exempt banks providing primarily retail banking services from the rules governing the provision of investment banking accounts. This exemption will apply as long as their investment banking is less than 10% of their tier 1 capital. (Tier 1 capital is currently the buffer which banks are required to retain in case of a crisis.) The changes were the outcome of a review conducted in 2022 but had not been implemented by the previous government.
The announcement has sparked a debate about ring-fencing, with some commentators calling for it to be removed altogether. Therefore, it is timely to revisit the rationale for ring-fencing. This blog examines what ring-fencing is and why it was introduced, and explains the associated economic costs and benefits.
Why was ring-fencing introduced?
Ring-fencing was recommended by the Independent Commission on Banking (ICB) in 2011 (see link below) and implemented through the Financial Services (Banking Reform) Act of 2013. The proposed separation of core retail banking services from investment banking were intended to address issues in banks which arose during the global financial crisis and which required substantial taxpayer bailouts. (See the 2011 blog, Taking the gambling out of high street banking (update).)
Following deregulation and liberalisation of financial services in the 1980s, many UK banks had extended their operations so that they combined domestic retail operations with substantial investment and international operations. The intention was to open up all dimensions of financial services to greater competition and allow banks to exploit economies of scope between retail and investment banking.
However, the risks associated with these services are very different but, in the period before the financial crisis, were provided alongside one another within banking groups.
One significant risk which was not fully recognised at the time was contagion – problems in one dimension of a bank’s activity could severely compromise its ability to provide services in other areas. This is what happened during the financial crisis. Many of the UK banks’ investment operations had made significant investments in off-balance sheet securitised debt instruments – CDOs being the most famous example. (See the 2018 blog, Lehman Brothers: have we learned the lessons 10 years on?.)
When that market crashed in 2007, several UK-based banks incurred significant losses, as did other banks around the world. Given their thin equity buffers and the inability to borrow due to a credit crunch, such banks found it impossible to bear these losses.
The UK government had to step in to save these institutions from failing. If it had not, there would have been significant economic and social costs associated with their inability to provide core retail banking functions. (See the 2017 blog, Ten years on.)
The Independent Commission proposed that ‘the risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers. Nor do ordinary depositors have the incentive (given deposit insurance to guard against runs) or the practical ability to monitor or bear those risks’ (p.9). Unstructured banks, with no separation of retail from investment activities, increase the potential for both of these stakeholder groups to bear the risks of investment banking.
Structural separation of retail and investment banking addresses this problem. First, separation should make it easier and less costly to resolve problems for banks that get into trouble, avoiding the need for taxpayer bailouts. Second, structural separation should help to insulate retail banking from external financial shocks, ensuring that customer deposits and essential banking services are protected.
Problems of ring-fencing
Ring-fencing has been subject to criticism, however, which has led to calls for it to be scrapped.
It must be noted that most of the criticism comes from banks themselves. They state that it required significant operational restructuring by UK banks subject to the regulatory framework which was complex and costly.
In addition, segregating activities can lead to inefficiencies, as banks may not be able to take full advantage of economies of scope between investment and retail banking. Furthermore, ring-fencing could lead to a misallocation of capital, where resources are trapped in one part of the bank and cannot be used to invest in other areas, potentially increasing the risks of the specific areas.
Assessing the new proposals
It is argued that the increased threshold proposed by the authorities may put UK institutions at a competitive disadvantage to outside entrants that are building market share from a low base. Smaller entrants do not have to engage in the costly restructuring that the larger UK incumbents have. They can exploit scope economies and capital mobility within their international businesses to cross-subsidise their retail services in the UK which incumbents with larger deposit-bases are not able to.
However, the UK market for retail banking has significant barriers to entry. Following the acquisition of Virgin Money by Nationwide, only six banking groups in the UK meet the current threshold (Barclays, HSBC, Lloyds Banking Group, NatWest Group, Santander UK and TSB). Indeed, all of those have deposits well above the proposed £35bn threshold. Consequently, raising the threshold should not add significant compliance and efficiency costs, while the potential benefits of greater competition for depositors and SMEs could be a substantial boost to investment and productivity. Furthermore, if the new US entrants do suffer problems, it will not be UK taxpayers who will be liable.
Have we been here before?
In many ways, ring-fencing is a throwback to a previous age of regulation.
One of the most famous Acts of Congress relating to finance and financial markets in the USA is the Glass-Steagall Act of 1933. The Act was passed in the aftermath of the 1929 Wall Street crash and the onset of the Great Depression in the USA. That witnessed significant bank failures across the country and problems were traced back to significant losses made by banks in their lending to investors during the speculative frenzy that preceded the stock market crash of 1929.
To prevent a repeat of the contagion and ensure financial stability, Glass-Steagall legislated to separate retail banks and investment banks.
In the UK, such separation had long existed due to the historical restrictions placed on investment banks operating in the City of London. In the late 20th century, the arguments for separation became outweighed by arguments for the liberalisation of markets to improve efficiency and competition in financial services. Banking was increasingly deregulated and separation disappeared as retail banks increasingly engaged in investment activities.
That cycle of deregulation reached its nadir in 2007 with the international financial crisis. The need to bail out banks made it clear that the supposed synergies between investment and retail banking were no compensation for the high costs of contagion in the financial system.
Regulators must be wary of calls for the removal of ring-fencing. Sir John Vickers (chairman of the independent commission on banking) highlighted the need to protect depositors, and more importantly taxpayers, from risks in banking. It is the banks that should bear the risks and manage them accordingly. Ultimately, it is up to the banks to do that better.
Articles
Bank annual reports
Access these annual reports to check the deposit base of these UK banks:
Information
Report
- Final Report: Recommendations
The Independent Commission on Banking, Sir John Vickers (Chair), Clare Spottiswoode, Martin Taylor, Bill Winters and Martin Wolf (September 2011)
Questions
- How did the structure of UK banks cause contagion risk in the period before the global financial crisis?
- How does ring-fencing aim to address this and protect depositors and taxpayers?
- Use the links to the annual reports of the covered banks to assess the extent of deposits held by the institutions in 2023. How far above the proposed buffer do the banks sit?
- Use your answer to 3) and economic concepts to analyse the impact on competition in the UK market for retail deposits of raising the threshold.
- What are the risks for financial stability of raising the threshold?
Each year the BBC hosts the Reith Lectures – a series of talks given by an eminent person in their field. This year’s lecturer is Mark Carney, former Governor of the Bank of England. His series of four weekly lectures began on 2 December 2020. Their topic is ‘How we get what we value’. As the BBC site states, the lectures:
chart how we have come to esteem financial value over human value and how we have gone from market economies to market societies. He argues that this has contributed to a trio of crises: of credit, Covid and climate. And the former Bank of England governor will outline how we can turn this around.
In lectures 2, 3 and 4, he looks at three crises and how they have shaped and are shaping what we value. The crises are the financial crisis of 2007–9, the coronavirus pandemic and the climate crisis. They have challenged how we value money, health and the environment respectively and, more broadly, have prompted people to question what is valuable for individuals and society, both today and into the future.
The questions posed by Carney are how can we establish what is valuable to individuals and society, how well are such values met by economies and how can mechanisms be improved to ensure that we make the best use of resources in meeting those values.
Value and the market
In the first lecture he probes the concept of value. He explores how economists and philosophers have tried to value the goods, services and human interactions that we desire.
First there is ‘objective value’ propounded by classical economists, such as Adam smith, David Ricardo and Karl Marx. Here the value of goods and services depends on the amount of resources used to make them and fundamentally on the amount of labour. In other words, value is a supply-side concept.
This he contrasts with ‘subjective value’. Here the value of goods and services depends on how well they satisfy wants – how much utility they give the consumer. For these neoclassical economists, value is in the eye of the beholder; it is a demand-side concept.
The two are reconciled in the market, with market prices reflecting the balance of demand and supply. Market prices provided a solution to the famous diamonds/water paradox (see Box 4.2 in Economics (10th edition) or Case Study 4.3 in Essentials of Economics (8th edition) – the paradox of ‘why water, which is essential for life, is virtually free, but diamonds, which have limited utility beyond their beauty, are so expensive.’ The answer is to do with scarcity and marginal utility. Because diamonds are rare, the marginal utility is high, even though the total utility is low. 
And because water is abundant, even though its total utility is high, for most people its marginal utility is low. In other words, the value at the margin depends on the balance of demand and supply. Diamonds are much scarcer than water.
But is the market balance the right balance? Are the values implied by the market the same as those of society? ‘Why do financial markets rate Amazon as one of the world’s most valuable companies, but the value of the vast region of the Amazon appears on no ledger until it’s stripped of its foliage and converted into farmland?’ – another paradox highlighted by Carney.
It has long been recognised that markets fail in a number of ways. They are not perfect, with large firms able to make supernormal profits by charging more and producing less, and consumers often being ill-informed and behaving impulsively or being swayed by clever marketing. And many valuable things that we experience, such as human interaction and the beauty of nature, are not bought and sold and thus do not appear in measures of GDP – one of the main ways of valuing a country.
What is more, many of things that are produced in the market have side-effects which are not reflected in prices. These externalities, whether good or bad, can be substantial: for example, the global warming caused by CO2 emissions from industry, transport and electricity production from fossil fuels.
And markets reflect people’s biases towards the present and hence lead to too little investment for the future, whether in healthcare, the environment or physical and social infrastructure. Markets reflect the scant regard many give to the damage we might be doing to the lives of future generations.
What is particularly corrosive, according to Carney, is the
drift from moral to market sentiments. …Increasingly, the value of something, some act or someone is equated with its monetary value, a monetary value that is determined by the market. The logic of buying and selling no longer applies only to material goods, but increasingly it governs the whole of life from the allocation of healthcare, education, public safety and environmental protection. …Market value is taken to represent intrinsic value, and if a good or activity is not in the market, it is not valued.
The drift from moral to market sentiments accelerated in the Thatcher/Regan era, when governments were portrayed as inefficient allocators, which stifled competition, innovation and the movement of capital. Deregulation and privatisation were the order of the day. This, according to Carney, ‘unleashed a new dynamism’ and ‘with the fall of communism at the end of the 1980s, the spread of the market grew unchecked.’
But this drift failed to recognise market failures. It has taken three crises, the financial crisis, Covid and the climate crisis to bring these failures to the top of the public agenda. They are examined in the other three lectures.
The Reith Lectures
Questions
- Distinguish between objective and subjective value.
- If your income rises, will you necessarily be happier? Explain.
- How is the concept of diminishing marginal utility of income relevant to explaining why ‘A Christmas bonus of £1000 means less to Mark Zuckerberg then £500 does to someone on a minimum wage.’
- Does the use of social cost–benefit analysis enable us to use adjusted prices as a measure of value?
- Listen to lectures 2, 3 and 4 and provide a 500-word summary of each.
- Assess the arguments Mark Carney uses in one of these three lectures.
Under the auspices of the Bank for International Settlements (BIS), banks around the world are working their way towards implementing tougher capital requirements. These tougher rules, known as ‘Basel III’, are due to come fully into operation by 2019.
This third version of international banking rules was agreed after the financial crisis of 2008, when many banks were so undercapitalised that they could not withstand the dramatic decline in the value of many of their assets and a withdrawal of funds.
Basel III requires banks to have much more capital, especially common equity capital. The point about equity (shares) is that it’s a liability that does not have to be repaid. If people hold bank shares, the bank does not have to repay them and does not even have to pay any dividends. In other words, the money raised by issuing shares carries no obligation on the part of the bank and can thus provide a buffer against large-scale withdrawal of funds.
Under Basel III, banks have to maintain sufficiently large ‘capital-adequacy ratios’. As Essentials of Economics (7th edition) explains:
Capital adequacy is a measure of a bank’s capital relative to its assets, where the assets are weighted according to the degree of risk. The more risky the assets, the greater the amount of capital that will be required.
A measure of capital adequacy is given by the capital adequacy ratio (CAR). This is given by the following formula:
Common Equity Tier 1 (CET1) capital includes bank reserves (from retained profits) and ordinary share capital (equities), where dividends to shareholders vary with the amount of profit the bank makes… Additional Tier 1 (AT1) capital consists largely of preference shares. These pay a fixed dividend (like company bonds), but although preference shareholders have a prior claim over ordinary shareholders on the company’s (i.e. the bank’s) profits, dividends need not be paid in times of loss.
Tier 2 capital is subordinated debt with a maturity greater than 5 years. Subordinated debt holders only have a claim on a company (a bank) after the claims of all other bondholders have been met.
Risk-weighted assets are the total value of assets, where each type of asset is multiplied by a risk factor. Under the Basel III accord, cash and government bonds have a risk factor of zero and are thus not included. Interbank lending between the major banks has a risk factor of 0.2 and is thus included at only 20 per cent of its value; residential mortgages under 60% of the value of the property have a risk factor of 0.35; personal loans, credit-card debt and overdrafts have a risk factor of 1; loans to companies carry a risk factor of 0.2, 0.5, 1 or 1.5, depending on the credit rating of the company. Thus the greater the average risk factor of a bank’s assets, the greater will be the value of its risk weighted assets, and the lower will be its CAR.
Basel III gives minimum capital requirements that are higher than under its predecessor, Basel II. Thus, by 2019, banks must have a common equity capital to risk-weighted assets of at least 4.5% and a Tier 1 ratio of at least 6.0%. The overall CAR should be at least 8%. In addition, the phased introduction of a ‘capital conservation buffer’ from 2016 will raise the overall CAR to at least 10.5 per cent.
Over the past few years, banks have increased their capital cushions significantly and many have exceeded the Basel III requirements, even for 2019.
But the Basel Committee has been reconsidering the calculation of risk-weighted assets. Because of the complexity of banks’ asset structures, which tend to vary significantly from country to country, it is difficult to ensure that banks’ are meeting the Basel III requirements. Under proposed amendments to Basel III (which some commentators have dubbed ‘Basel IV’), banks would have to compare their own calculations with a ‘standardised’ model. Their own calculations of risk-based assets would then not be allowed to be lower than 60–90% (known as ‘the output floor’) of the standardised approach.
While, on the surface, this may seem reasonable, European banks have claimed that this would penalise them, as some of their assets are less risky than the equivalent assets in other countries. For example, Germany has argued that mortgage defaults have been rare and thus German mortgage debt should be given a lower weighting than US mortgage debt, where defaults have been more common. If all assets were assessed according to the output floor, several banks, especially in Europe, would be judged to be undercapitalised. As The Economist article states:
Analysts at Morgan Stanley estimate that global, non-American banks could see risk-weighted assets rise by an average of 18–30%, depending on the level of the output floor. Extra capital of €250bn–410bn could be needed, a tall order when earnings are thin and investors wary. The committee’s reviews of operational and market risks would add even more.
This question of an output floor was a sticking point at the Basel Committee meeting in Santiago, which ended on 30 November. Although some progress was made about agreeing to rules on risk weighting that could be applied globally, a final agreement will have to wait until the next meeting, in January – at the earliest.
Articles
Basel bust-up: A showdown looms over bank-capital rules The Economist (26/11/16)
Bank regulators fail to agree on new rules Manila Standard (2/12/16)
Bank chief Claudio Borio urges regulators to ‘stay strong’ Weekend Australian, Michael Bennet (29/11/16)
Final Basel III rules meet resistance from Europe The Straits Times (2/12/16)
This Is the Absolutely Worst Time to Weaken Global Bank Rules American Banker, Mayra Rodriguez Valladares (2/12/16)
New Basel banking rules’ impact on European economy Financial Times, Frédéric Oudéa (28/12/16)
Banks like RBS still look risky, but getting too tough could cause greater problems The Conversation, Alan Shipman (1/12/16)
BIS publications
International banking supervisory community meets to discuss the regulatory framework BIS Press Release (1/12/16)
Basel III: international regulatory framework for banks Bank for International Settlements
Basel III phase-in arrangements Basel Committee on Banking Supervision, BIS
Basel Committee on Banking Supervision reforms – Basel III, Summary Table Basel Committee on Banking Supervision, BIS
Questions
- Why do reserves in banks have a zero weighting in terms of risk-based assets?
- What items have a 100% weighting? Explain why.
- Examine the table, Basel III phase-in arrangements, and explain each of the terms.
- If banks are forced to operate with a higher capital adequacy ratio, what is this likely to do to bank lending? Explain. How are funding costs relevant to your answer?
- Explain each of the items in the Basel III capital-adequacy requirements shown in the chart above.
- What is the American case for imposing an output floor?
- What is the European banks’ case for using their own risk weighting?
- Why is it proposed that larger ‘systemically important banks’ (SIBs) should have an additional capital requirement?
- How does the balance of assets of American banks differ from that of European banks?
The Brexit vote has caused shockwaves throughout European economies. But there is a potentially larger economic and political problem facing the EU and the eurozone more specifically. And that is the state of the Italian banking system and the Italian economy.
Italy is the third largest economy in the eurozone after Germany and France. Any serious economic weaknesses could have profound consequences for the rest of the eurozone and beyond.
At 135% of GDP, Italy’s public-sector debt is one the highest in the world; its banks are undercapitalised with a high proportion of bad debt; and it is still struggling to recover from the crisis of 2008–9. The Economist article elaborates:
The adult employment rate is lower than in any EU country bar Greece. The economy has been moribund for years, suffocated by over-regulation and feeble productivity. Amid stagnation and deflation, Italy’s banks are in deep trouble, burdened by some €360 billion of souring loans, the equivalent of a fifth of the country’s GDP. Collectively they have provisioned for only 45% of that amount. At best, Italy’s weak banks will throttle the country’s growth; at worst, some will go bust.
Since 2007, the economy has shrunk by 10%. And potential output has fallen too, as firms have closed. Unemployment is over 11%, with youth unemployment around 40%.
Things seem to be coming to a head. As confidence in the Italian banking system plummets, the Italian government would like to bail out the banks to try to restore confidence and encourage deposits and lending. But under new eurozone rules designed to protect taxpayers, it requires that the first line of support should be from bondholders. Such support is known as a ‘bail-in’.
If bondholders were large institutional investors, this might not be such a problem, but a significant proportion of bank bonds in Italy are held by small investors, encouraged to do so by tax relief. Bailing in the banks by requiring bondholders to bear significant losses in the value of their bonds could undermine the savings of many Italians and cause them severe hardship, especially those who had saved for their retirement.
So what is the solution? Italian banks need recapitalising to restore confidence and prevent a more serious crisis. However, there is limited scope for bailing in, unless small investors can be protected. And eurozone rules provide little scope for government funding for the banks. These rules should be relaxed under extreme circumstances. At the same time, policy needs to focus on making Italian banking more efficient.
Meanwhile, the IMF is forecasting that Italian economic growth will be less than 1% this year and little better in 2017. Part of the problem, claims the IMF, is the Brexit vote. This has heightened financial market volatility and increasead the risks for Italy with its fragile banking system. But the problems of the Italian economy run deeper and will require various supply-side policies to tackle low productivity, corruption, public-sector inefficiency and a financial system not fit for purpose. What the mix of these policies should be – whether market based or interventionist – is not just a question of effectiveness, but of political viability and democratic support.
Articles
The Italian Job The Economist (9/7/16)
IMF warns Italy of two-decade-long recessionThe Guardian, Larry Elliott (11/7/16)
Italy economy: IMF says country has ‘two lost decades’ of growth BBC News (12/7/16)
What’s the problem with Italian banks? BBC News, Andrew Walker (10/7/16)
Why Italy’s banking crisis will shake the eurozone to its core The Telegraph, Tim Wallace Szu Ping Chan (16/8/16)
If You Thought Brexit Was Bad Wait Until The Italian Banks All Go Bust Forbes, Tim Worstall (17/7/16)
In the euro zone’s latest crisis, Italy is torn between saving the banks or saving its people Quartz, Cassie Werber (13/7/16)
Why Italy could be the next European country to face an economic crisis Vox, Timothy B. Lee (8/7/16)
Forget Brexit, Quitaly is Europe’s next worry The Guardian, Larry Elliott (26/7/16)
Report
Italy IMF Country Report No. 16/222 (July 2016)
Data
Economic Outlook OECD (June 2016) (select ‘By country’ from the left-hand panel and then choose ‘Italy’ from the pull-down menu and choose appropriate time series)
Questions
- Can changes in aggregate demand have supply-side consequences? Explain.
- Explain why there may be a downward spiral of asset sales by banks.
- How might the principle of bail-ins for undercapitalised Italian banks be pursued without being at the expense of the small saver?
- What lessons are there from Japan’s ‘three arrows’ for Italy? Does being in the eurozone constrain Italy’s ability to adopt any or all of these three categories of policy?
- Why may the Brexit vote have more serious consequences for Italy than many other European economies?
- Find out what reforms have already been adopted or are being pursued by the Italian government. How successful are they likely to be in increasing Italian growth and productivity?
- What external factors are currently (a) favourable, (b) unfavourable to improving Italian growth and productivity?
